BMO’s autocall barrier enhanced return notes on Russell 2000 seen as ‘hybrid’ play

By Emma Trincal

New York, Sept. 14 – Bank of Montreal’s 0% autocallable barrier enhanced return notes due Oct. 3, 2025 linked to the Russell 2000 index are one among a growing number of notes offering investors a one-time call premium along with the potential for uncapped leverage at maturity.

If the index is above its initial level on Oct. 5, 2023, the notes will be automatically redeemed early at par plus a call premium of 13.5% per annum, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not redeemed early, the payout at maturity will be par plus 150% of any index gain.

Investors will receive par if the index falls by up to 30%. Otherwise, investors will be fully exposed to the index’s decline from its initial level.

Seen before

Brady Beals, director, sales and product origination at Luma Financial Technologies, said he noticed the growing popularity of such notes, which are characterized by a one-time autocall and participation at maturity. But he stressed some of their shortcomings.

“Originally, I remember seeing notes a little bit similar to this but with some differences,” he said.

“Instead of getting a call premium, you were receiving a monthly fixed coupon usually in the 5% to 6% range.

“Those notes used to be sold only by private banks. If you weren’t called, you would get uncapped leverage at maturity just like this one.”

The “new generation” of these hybrid notes offers a premium upon the call, not a fixed interest rate.

“The call premium is going to be much higher of course since you only get paid if you’re called,” he said.

Single asset

Looking at the BMO deal, he said the issuer was “a little bit more aggressive” than other similar trades. The notes pay a relatively high premium of 13.5% per year and use the Russell 2000, an underlier that is more volatile than the S&P 500 index.

Almost all of those structures combining a one-time call and uncapped participation at maturity are linked to a single index, a market participant noted.

“But here there’s also something specific to BMO. They’ve done tons of worst-of and they’re now reassessing the risk. For now, they’re trying to do more single index deals. Not that anything wrong came out of their worst-of. But they want to make sure they have the right risk controls in place,” this market participant said.

Brokerage product

Beals said that the structure in general may appeal to some investors but not all.

“It’s very hybrid. Our clients haven’t really pivoted to this kind of notes,” he said.

He said he has seen more activity around five-year products with a one-time call after two years.

“We think those structures are more of a brokerage trade than something you’re going to see in the RIA space,” he said.

The reason behind such a view was the difficulty advisers face when allocating the product.

“It’s not sitting easily in the portfolio. Is it income? Is it growth? What are you trying to accomplish? For the purpose of asset allocation, which is the mission of most RIAs, it’s a little bit too hybrid,” he said.

A financial adviser agreed.

“We like those deals but it’s just hard to know if it’s an income note or a growth note,” he said.

“Back in May when the market was down, we did one. A four-year term on the S&P with a one-year autocall paying 15% in premium. You had 1.8x leverage, no cap and a 75% barrier. I think that was a pretty good deal. You’re probably better off when there is more time between the call and maturity.”

Optics and pricing

The “optics” of the structure look “pretty good,” said Beals. But the risks should not be overlooked.

To make his point, he compared the pricing of this “hybrid” structure with a typical snowball, in which several call dates give investors a greater opportunity to get paid while a memory feature allows them to cumulate the premium.

A three-year snowball paying a 13.5% call premium would yield 40.5% at maturity, which for the issuer is “expensive” to price, he explained.

“Flip the snowball to this structure. If the notes are not called on the first year, you’re negative. You’re buying a call or a call and a half at that point. From the issuer’s perspective, it’s cheaper. The index only has two years to recover and while it may very well recover, it may not give you a lot of upside.”

BMO Capital Markets Corp. is the agent.

The notes will price on Sept. 28 and settle on Oct. 3.

The Cusip number is 06374V4P8.

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